Fiscal Costs of Hidden Deficits: Beware—When It Rains, It Pours

Budgets can be full of surprises. And not always good ones. Often times, debt increases significantly because an unforeseen obligation materializes. These contingent liabilities, as they are known in the economist’s jargon, can have significant economic and fiscal costs. In fact, on many occasions, large and unexpected increases in debt across the world were due to the materialization of contingent liabilities. That is why they are often called hidden deficits.

To gain a better understanding of these liabilities, we have created in a recent paper, a new dataset documenting over 200 episodes (covering 80 countries over the period 1990–2014), involving the materialization of contingent liabilities.

How it works

Simply put, a contingent fiscal liability is a potential obligation for the government, which depends on a possible future event. Here is how it works. If a government provides a guarantee for a public or private company’s loan and the company fails to make payments, the lender will call the guarantee. Consequence: the government will have to take the loan on its books. These liabilities can be embedded into explicit contracts like a loan guarantee, but they can also be implicit.

For example, governments are often expected to cover the debts of local authorities or state-owned enterprises when these are unable to pay. Sometimes, governments also incur substantial costs from financial sector bailouts. Countries like Australia and the United Kingdom, record, monitor, disclose, and manage these potential liabilities to minimize risks to their budgets. However, in most cases, taxpayers only know about them when it’s too late. That is, when these liabilities are no longer “potential” but “actual.”

Costly deficits

The key finding is that the fiscal cost of these liabilities is large. The cost averages 6 percent of Gross Domestic Product (GDP) and in some cases exceeds 20 percent of GDP (see chart). Given that it happens every 12 years in the average country, potential cost is about half percent of GDP per year. However, this average masks important differences between countries. Not all countries are equally likely to experience these costs. For example, in Brazil, it happened on average every 5–6 years and cost 8.3 percent of GDP. The incidence was much lower in countries like Canada, Hong Kong and Israel.

Digging deeper, we also find that support to the financial sector, including bailouts, accounts for the largest share of these unexpected costs. Think of Indonesia, Thailand and Korea during the Asian Crisis. Or, think Iceland and Ireland during the recent global financial crisis. Subnational government bailouts, support to state-owned enterprises and legal liabilities also give rise to substantial costs (see table). Examples of these include Argentina (2001–2004), Greece (2007–2010) and Macedonia (starting in 1999).

Additionally, our analysis also shows that liabilities tend to materialize after periods of high growth and coincide with low growth periods and banking crises. And, they tend to happen at the same time, putting considerable strain on government finances. When it rains, it pours. The Asian Crisis and the Global Financial Crisis are prime examples.

We have also learned that countries with stronger institutions and lower growth volatility tend to suffer less from contingent liability realizations. Indeed, countries with strong public institutions could face a cost which is 30 percent lower than the average.

Avoiding bad surprises

What are the lessons for policymakers?

First, countries must build strong institutions to avoid the emergence of these liabilities. It means better governance at the local government level, in state owned-enterprises, and public-private partnerships. It also means stronger supervision and better resolution regimes for financial sector institutions to avoid the taxpayer having to pay for financial sector bailouts, the most costly source of liabilities.

Second, governments need to put in place more transparent and better arrangements for disclosing and monitoring their hidden liabilities. In particular, fiscal frameworks should be strengthened to enhance discipline and limit the excessive growth of contingent liabilities. This is particularly important because the evidence shows that these hidden deficits tend to emerge in times of financial distress when public finances are the weakest.

Needless to say that it is better to avoid bad surprises in the budget during these difficult times.